China stocks bear risk of capitulation in 2013

Commentary: China’s new leaders can expect short honeymoon

HONG KONG (MarketWatch) — A strong end to the year for Shanghai A-shares has raised expectations for Chinese equities in 2013. A string of better economic numbers and hopes that a new leadership will be more reform-minded has buoyed sentiment.

Still, many of the factors that plagued mainland Chinese stocks last year remain in the year ahead.

China may have new faces in its leadership, but it faces the same old problems with its economy.

A key question is the sustainability of China’s growth — after all, its financial markets have underperformed, down over 60%, since the global financial crisis.

So will 2013 be different? The worry is that rather than a year of change, 2013 could be the year of reckoning, when a raft of major structural economic problems — years in the making — come to a head.

The stakes are now high, warn analysts. Bank of America Merrill Lynch says in its strategy outlook that if the new leadership misses the mark in dealing with various structural problems, 2013 risks being a year of capitulation for Chinese equities.

For now, the administration of incoming president Xi Jinping is still in a honeymoon period, but investors will want to see further evidence the economy is in fact healing and reform efforts are serious.

Bank of America Merrill Lynch reckons that some of the major structural issues, such as unstable financial markets, overreliance on property purchases and local-government investment, have actually worsened in recent months.

Capital Economics notes that recent stronger economic data are mainly being driven by a turnaround in heavy industry that is linked to infrastructure spending.

For investors looking for evidence China is dealing with its structural imbalances following its earlier spending binge, this will hardly be reassuring.

China’s property market could emerge as a bigger risk in 2013. Since 2010, mainland Chinese authorities have had curbs in place in an attempt to deflate one of the world’s largest property booms.

The common narrative is of a managed decline, yet there are some signs it could get messy.

In the city of Wenzhou, Zhejiang province, property prices have now fallen 60% from their peak in 2010, the South China Morning Post reported last week.

The worry is the fallout from a property slowdown will extend far beyond developers and property owners. Slow land sales cut off a key funding source for local governments. A revenue crunch was avoided last year when banks were permitted to roll over loans of various municipal borrowers.

This, however, weakens banks balance sheets. A notable trend towards the end of the year was a slowdown in lending by the “Big Four” banks.

Another concern flagged by Bank of America is financial stability. This has resurfaced in recent weeks with renewed fears over the health of wealth management products (WMPs), which have put the 7 trillion yuan ($1.12 trillion yuan) industry in the spotlight.

Last week, China Construction Bank Corp.
0939, -1.87%CICHF, +3.13%601939, +3.66%
said it was investigating complaints after one of its WMPs lost more than 30%. This comes on the heels of a Hua Xia Bank
600015, +1.51%
branch near Shanghai failing to pay out on maturity on some products late last month.

Authorities face a dilemma if a WMP problem escalates. On one hand, there is the moral hazard of bailing out these products, while on the other, there’s the wider systematic risk of a run on WMPs.

Meanwhile, the government appears to have less room to turn on the spending taps to deal with unexpected economic shocks.

Overall leverage in the Chinese economy increased by 15 percentage points to 205% of gross domestic product last year, according to Standard Chartered Bank.

They said banks’ non-performing loans and corporate receivables started to rise in 2012, and these are likely to become bigger problems in 2013.

Further piling on the pressure for policy makers is that exports — long a key pillar of China’s economy — are in decline.

Standard Chartered cited an inexorable slide in real growth in the past year, particularly in manufacturing.

The slowdown is in not just due to a weaker export markets, but also structural factors as factories relocate to cheaper locations.

This looks to be more than a transitory slump, as foreign direct investment has been on a downward trend throughout 2012.

And as well as China’s days of double-digit exports being over, so too are its ever-rising trade surpluses.

There was an early warning of this when China recorded a trade deficit in the second quarter of 2012. One consequence is that authorities will no longer be able to keep expanding money supply by recycling surpluses.

China’s new leaders face some daunting challenges in 2013. Investors betting on an equity-market recovery might want to wait for evidence the new government is up to the task. Anything less could see China’s long suffering A-share investors throw in the towel.

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